Packages of Newport cigarettes are displayed at a tobacco shop in San Francisco. / Justin Sullivan, Getty Images

by Wendy Koch, USA TODAY

by Wendy Koch, USA TODAY

As the U.S. cigarette market dips, the nation's second-largest tobacco company, Reynolds American, announced Tuesday that it plans to buy the third-largest one, Lorillard, for about $27.4 billion, creating a rival for market leader and Marlboro maker Altria.

Reynolds, maker of Camel and Pall Mall, will acquire Lorillard, maker of Newport, for cash and stock valued at $68.88 per Lorillard share. The deal, which includes assumption of Lorillard debt, is one of the largest ever in the tobacco industry and will likely face scrutiny from regulators.

To allay regulators' concerns, the companies said they would sell some of their smaller brands to Imperial Tobacco for $7.1 billion, making Imperial the third-largest U.S. tobacco company, with a 10% market share. Reynolds will sell Winston, Kool and Salem, which account for a combined 5% of the cigarette market, and Lorillard will sell its e-cigarette brand Blu eCigs, which dominates what has been a booming market for the e-devices.

Some analysts were taken aback by Blu's sale, because they said the brand was one of the reasons Reynolds was interested in Lorillard, which acquired it in 2012. "We were surprised to see the Blu divestiture," Wells Fargo tobacco analyst Bonnie Herzog said Tuesday in a research note.

Yet Reynolds President and CEO Susan Cameron, in announcing the deal, made clear that the company plans to take on the e-cigarette market with its own new Vuse product, rolled out nationally last month. She said Vuse offers "superior technology" and told investors Tuesday that Reynolds is ramping up the brand's production. "We're selling it very quickly," she said.

Reynolds' stock closed down 6.9% to $58.84 Tuesday while Lorillard's shares fell 10.5% to $60.17. Michael Lavery, tobacco analyst at New York-based CLSA, said Lorillard's stock is falling, because "people don't expect this (acquisition) is a slam dunk" for antitrust reasons.

The consolidation could boost the ability of Winston-Salem, N.C.-based Reynolds to take on Altria, owner of Philip Morris USA, which alone holds 46% of the U.S. cigarette market, according to Euromonitor International. Reynolds currently has 25% of the market mostly because of Pall Mall and Camel, which each comprise 8%. Lorillard has 12% due almost entirely to Newport.

Altria spokesman David Sylvia said Tuesday the company has no comment on Reynolds' plan to buy Lorillard.

The market for conventional cigarettes has steadily fallen, shrinking nearly a fifth from 2008 to 2013, as the share of U.S. adults who smoke has fallen from 42% in 1965 to 33% in 1980, 25% in 1995 and 18% in 2012, according to data from the Centers for Disease Control and Prevention.

In contrast, sales of other types of tobacco that have not faced the same degree of federal regulation and taxation - notably smokeless and e-cigarettes - have fared better, so cigarette makers have been diversifying their product lines. Smokeless products continue to grow at about 5% per year, says Cowen tobacco analyst Vivien Azer.

"This is a win-win," Cameron told investors in a morning conference call. In the company's announcement, she said that Reynolds and Lorillard have "complementary core strengths, and the addition of Newport to our operating companies' existing key brand portfolios ... will enhance our ability to compete in the combustible cigarette and smokeless categories."

British American Tobacco will maintain its 42% ownership of Reynolds, and Greensboro, N.C.-based Lorillard shareholders will hold 15% of newly expanded Reynolds' shares. Lorillard CEO Murray Kessler will join Reynolds' board once the deal is complete. Cameron said the acquisition will give Reynolds "additional resources to invest in innovation, R&D and its operating companies' brands."

That worries public health advocates. "There's serious concern that a merged company with increased resources poses a real threat to increased tobacco marketing to America's kids," said Matthew Myers, president of the Campaign for Tobacco-Free Kids.

"This is a marriage of Joe Camel and Newport - two brands that have played a major role in youth tobacco use," Myers said. He also said Reynolds aggressively markets Grizzly, the most popular smokeless tobacco brand among youth, to teenagers.

CLSA's Lavery said the deal will enable Reynolds to consolidate production, sales and overhead. "There's real savings there," he said. Reynolds said it expects savings of about $800 million by reducing corporate expenses and selling some brands.

Still, Lavery questioned the deal because of uncertainty about federal regulation of menthol cigarettes, which comprise 85% of Lorillard's total sales. The U.S. Food and Drug Administration banned other flavors in cigarettes in 2009 and issued a report last year that said menthol cigarettes contribute to youth tobacco addiction. The FDA, which proposed rules for e-cigarettes in April, has not said whether it will regulate or ban menthol cigarettes.

"It's a lot of money to spend without knowing that," Lavery said.

In its announcement, Reynolds said the addition of Newport is a "key component" of its future growth strategy. Cameron said the company is confident that the FDA will make "reasonable, science-based regulatory decisions." She said current scientific evidence suggests menthol does not increase a cigarette's health risks.

Azer said Newport, unlike the overall menthol category, continues to increase the number of cigarettes sold. She said Newport's share of the young adult market - those ages 18 to 25 - has increased from 16% in 1999 to 22% in 2012. Reynolds' Camel brand has also increased its market share among young adults, from 11% in 1999 to 17% in 2012, while Marlboro's dominance has fallen from 57% to 43% during that 13-year period.

Because of the growth of Newports and Camels among young smokers, Azer expects the Federal Trade Commission will closely scrutinize Reynolds' acquisition of Lorillard. "It's going to be very hard to get this deal approved at the end of the day," she said.

Wells Fargo's Herzog said she was surprised that the price paid for Lorillard was $68.88 a share, because she sees its shares worth as $72 or more. She said the acquisition will deliver greater cost savings than initially anticipated, will benefit Reynolds and Lorillard shareholders and create a stronger No. 2 tobacco company in the United States.